International Monetary System in 1925-1960 - Essay Example

International Finance: (International Monetary System 1925-1960) Table of Contents a. 4 b. 9 Reference 13 a. Introduction: International monetary system facilitates international trade, cross border investment and reallocation of capital between nation states (Rodrigue, 2013, p.1). They promote means of payment between buyers and sellers of different nations including deferred payments. It provides the framework for ensuring liquidity without fuelling inflation and corrects the global imbalances or restricts their emergence, while facilitating an orderly payment system. The Industrial Revolution increased the production of goods and widened the basis of world trade (Hodge, 2008, p.287). At that time the necessary condition to promote world trade was a stable exchange rate system. Stable exchange rate system encourages and settles commercial transactions across borders. That’s why by the second half of the 19th century, most countries had adopted the gold standards exchange rate regime. The requirement of gold standard regime was that, domestic currencies should be defined in terms of a specific weight of gold. It also required that each country adjust its domestic money supply in direct relation to the amount of gold it held. Background World war I & II World War I It took place in Europe in August 1914 and lasted until 11 November 1918. It was one of the most violent and destructive wars in European history. (Keylor, 2001, p.1).All the world’s great powers which were assembled in two opposing alliances were involved in it. The opposing alliances were the Allies and the Central Powers. Both alliances reorganized and expanded as more nations entered the war. More than 70 million personnel were mobilized in this war. And more than 9 million were killed because of technological advancement that led to increase in the lethality of weapons without corresponding improvement in mobility. It paves the way for various political changes. In the 19th Century the European Powers, in order to maintain a Balance of Power throughout Europe, resulted in the existence of a complex network of political and military alliances throughout the continent. There also arose a miscommunication among the strategies of Central Powers. Germany had promised that it will support Austria-Hungary’s invasion of Serbia, but interpretation of all these came in different way and this also give rise to conflict. World War II This arose due to the instability created by the World War I in Europe. It broke out two decades later and proved more devastating. Hitler’s invasion of Poland in September 1939 drove Great Britain and France to declare war on Germany and this gave rise to World War II. (Guisepi, 2006, p.1). The lingering antipathy over the ruthless terms which is forced by the Versailles Treaty and the political and economic unsteadiness in Germany fueled the rise to power of National Socialist (Nazi) Party and Adolf Hitler. Hitler created a totalitarian single- party state led by Nazis. He believed that the living space could be gain only through war. After signing alliances with Italy and Japan against the Soviet Union, he sent troops to occupy Austria in 1938. World War II altered the political alignment and social structure of the world. The United Nations was established to foster international cooperation and prevent future conflicts. Territorial, colonial, and financial losses caused in Germany due to the Treaty of Versailles. Under the treaty, Germany lost around 13 percent of its home territory and all of its overseas colonies. After an unsuccessful attempt to overthrow the German Government in 1923, Adolf Hitler became the Chancellor of Germany in 1933 and he abolished democracy (ushmm, 2013, p.1) Monetary System before World War I From the 1870’s to the outbreak of World War I in 1914, the world benefited from a well integrated financial orders also known as First Stage of Globalization. The monetary system before World War I was the traditional Gold Standard 1875-1914. During the classical gold standard system, major countries agreed that gold would be guaranteed of unobstructed coinage, there would be cooperative convertibility between national currencies and gold at a constant ratio and gold would be liberally exported and imported.(Gaspar, 2012, p.1). Monetary System before World War II World War I ended the traditional gold standard as most important countries balanced recovery of banknotes in gold and forced embargo on gold exports. The U.S, which replaced Britain as the dominant financial power, spearheads efforts to store the gold standard again. The gold standard of the late 1920s was a façade as major countries gave priority to stabilization of domestic economies by similar inflows and outflows of gold with reduction and increase in domestic money and credit. Moreover, after the World War II Bretton Woods System came into picture (Eun and Resnick, 2010, p.29). Steps taken to regain normalcy after World War I United Nation Development Programme (UNDP): It was created to remove poverty, the social mobilization of women, respect for the environment and the reinforcement of democratic institutions. United Nations Educational, Scientific and Cultural Organization (UNESCO): It promoted education and give access to education, science, culture and communication. It also ensures that justice, the law, human rights and fundamental freedom are respected irrespective of race, sex, language or religion (Unac, 2000, p.1). United Nation Environment Programme (UNEP): It initiates the international legal framework for environmental protection. United Nation High Commissioner for Human Rights (UNHCHR): It is to promote respect for human rights. Steps taken to regain normalcy after world war II Following steps has been taken to regain normalcy after World War II: The changes in Government Policies: After the World War II most European Governments, by more government investments stimulated the economic growth of their country. More government investment encouraged private investment, created employment opportunities and led to continuing economic growth of Europe. The French decided to provide the financial resources for setting up a new transport system for modernizing the machines on the basic industries, for constructing more houses and for improving farming facilities. Growth in world trade: Taffies were reduced between European States for both the organizations. Intra-European traffic increases as a result of the decrease in tariffs (Ferraro, Santos, and Ginocchio, 1997, p.1). After 1945 by the general increases in the price of raw material, the primary producers in Asia and Africa were also benefitted. Scientific and technological advancement: After the war both chemical and electrical engineering industries made great changes. New varieties of chemical and electrical products were made after the Second World War Washing machines, radios, refrigerators, and television sets were also manufactured in large volumes and sold at low prices. Foreign aid: Foreign aid like UNRRA was formed. It helped in providing first aid to the nations that were just enlightened from Nazi domination. It also helped the countries which were badly affected from war to reconstruct their communication system and to regenerate their industry and agriculture. The World Bank and International Monetary Fund (IMF) have been set up to lent money to war-torn countries for the purpose of reconstruction and to provide short-term loans to nations having temporary unbalance of payments. And European Recovery Program was set up to rebuild their economy on a co-operative basis( Addison, and Tarp, 2012, p.14 and p.17). Critical Review Monetary System of World War I: World War I marked the beginning of the end of the Gold Standards. During the war, countries suspended the convertibility of their currencies into gold. After WWI various attempts were made to restore the “classical” gold standards. Those were: United States returned to a gold standard in 1919 and Great Britain joined, followed by France and Switzerland in 1925(Bordo, 1998, p.1). Monetary system of World War II: In July 1944 World War II came to an end and all 44 allied countries met in Bretton Woods for the purpose of establishing a new international monetary system. At Bretton Woods countries agreed upon fixed exchange rates regime for restarting world trade and global investment. The key points of Bretton Woods were pegging the U.S. dollar to gold at $35 per ounce and all other countries peg their currencies to the U.S. dollar. And the countries were agreed to “support” their exchange rates within + or -1% of these par values. This is done through buying or selling of foreign exchange when market forces needed to be offset. Argument and Implications U.S. balance of payment move towards the deficit stage. Dollar is “overestimated”. Foreigners become alarmed about holding overestimated U.S. dollar at a rate of $35 an ounce. The Bretton Woods fixed exchange rate system came to an end and floating exchange rate system came into picture. Managed rate regime also took place where governments’ managing their currency’s with regard to a reference currency. And in Pegged exchange regime, governments link the value of its currency relative to a reference currency ( Drabek, and Brada, 1998, p.6. p.7. and p.8). b. Introduction Purchasing Power Parity (PPP) is an economic theory that is used to determine the economic value of currencies (Mankiw, 2011, p.686). It states that, in two countries how much money would be needed to purchase same goods and services, and uses it to calculate the inherent foreign exchange rate. Therefore the amount of money thus has the similar purchasing power in different countries using that PPP rate. It shows how the exchange rate of two currencies should reflect the purchasing power of the people in two countries ( wisegeek, 2013, p.1). The concept is based on the law of one price, which means that in the absence of transaction cost and official trade barriers, the goods which are identical will have the same price in different markets when the prices are expressed in the same currency. If there comes a deviation from parity then it implies differences in purchasing power of a “basket of goods” across countries ( Sarnoa,b, and Passaria, 2011, p.1). Background Absolute Purchasing Power Parity It says that the value of two currencies change in inverse proportion to the changes in the ratio of price levels. For absolute PPP following conditions must be met. First the price index for each of the two countries must be comprised of the same basket of goods. Second the goods of each country must be freely tradable on the international market. And third, all of the prices need to be indexed to the same year ( Officer, 1978, p.562). Relative Purchasing Power Parity It predicts a relationship between the inflation rates of two countries over a specified period and the movement in the exchange rate between their two currencies over the same period which means that the exchange rate of two currencies reflects the effect of inflation rate. It states that the country having the higher inflation rate is the weaker currency because inflation reduces the real purchasing power of a nation’s currency. And this is measured over a period of time ( Murphy, p.1). Critical Review Comparison between Relative PPP and Absolute PPP Absolute PPP is base on the law of 1 price, which state that the similar basket of goods should be sold for the similar price all over the place. On the other hand, relative PPP state that the exchange rates can be attuned according to the inflation differential accessible in two markets ( econ, 2000, p.1). Empirical evidence of Absolute and Relative PPP Example of absolute PPP: A mango costs 2 dollar in country X and the same mango costs 4 dollars in country Y. This means 2 dollar in country X equals to 4 dollar in country Y. This exchange rate is based on cost of mango and it is assumed that the cost of mango is same worldwide. Example of relative PPP: Mexico’s anticipated annual rate of inflation is equal to 8% per year, while the anticipated annual inflation rate for the U.S. is 4%. As an approximation, it is expected that the Mexican peso would devalued at the rate of 4% a year. Argument against Purchasing Power Parity The forex market does not take into consideration the purchasing power parity because the whole concept is based on unrealistic assumptions such as consumptions patterns are the same all over the world, basket of goods and services in the CPI is the same in all countries, and no transportation cost. Measurement problem in testing for PPP For Absolute PPP: Suppose soybeans are currently priced at $5 a bushel in the U.S., that soybeans are prices at -5.50 per bushel in Europe, and that the exchange rate is 1.10 Euros per dollar. Now suppose that the price of soybeans goes up to -6.05 per bushel (a 10% increase) in Europe, while the price of soybeans in the U.S. only goes up on 5%, to $5.25 a bushel. If there is no depreciation in the euro to offset the 5% difference, then European soybeans will not be competitive on the international market and trade flowing from the U.S. to Europe will greatly decrease. For Relative PPP: Suppose that the annual inflation rate is expected to be 8% in the Eurozone and 2% in the U.S. The current exchange rate is $1.20 per euro (-1.00 = $1.20). What would be the expected spot exchange rate be in 6 months for the euro? Ans: S1 /S0 = (1 + Iy) / (1 + Ix) Therefore S0.5 /S0 = ((1 + IUS) / (1 + Ieurozone))0.5 = S0.5 / $1.20 per euro = (1.02 / 1.08)0.5 ; which implies S0.5 = (1.20) * 0.978125 = 1.1662 So the expected spot exchange rate at the end of 6 month would be $1.1662 per euro. Reference Unac., 2000. The United Nations and the Culture of Peace. [online]. 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